The Hickory Fund returned -27.69% in the first quarter of 2020, compared to -27.07% for the Russell Midcap index (the Fund’s primary benchmark). For the year ending March 31, 2020, the Fund returned -15.67% compared to -18.31% for the benchmark.
The COVID-19 crisis has unfurled at an alarming pace, disrupting our daily lives and the global economy seemingly overnight. The situation remains incredibly dynamic as investors grapple with the consequences of the virus itself, the potential consequences of shutting down economies (both here and abroad) and the power of monetary policy and fiscal stimulus to combat the recession. The magnitude of this uncertainty has manifested itself in violent swings in stock prices, volatility we’ve not experienced since the Great Financial Crisis of 2008-2009. Against this highly fluid backdrop, our commentary reflects performance and activity through March 31, a period that incorporates the beginning of the pandemic but obviously not its eventual resolution.
Stocks and other risk assets were pummeled as the economy ground to a near halt in March, and only three stocks contributed positively to performance. EverArc Holdings (LSE:EVRA, Financial) and Equity Commonwealth (EQC, Financial) both derive nearly all their value from the large sums of cash sitting on their balance sheets. Acquisition vehicle EverArc Holdings raised capital in late 2019 and continues to evaluate opportunities to purchase one or more operating businesses. Market-wide asset price declines suggest improving potential returns when EverArc ultimately deploys its war chest of cash. In recent years, Equity Commonwealth opted to capitalize on frothy commercial real estate prices by liquidating nearly all its portfolio for cash. Today, this war chest gives chairman Sam Zell and company lots of optionality for value creation. Lastly, as the market swooned, we initiated a new position in IDEX Corp. (IEX, Financial) (maker of highly engineered pumps, dispensing solutions, and other components enabling the movement of fluids and gasses) which has delivered strong early returns.
The rest of our holdings participated in the sell -off to varying degrees, but long-time holding Redwood Trust (RWT, Financial) deserves individual attention. The non-agency mortgage market is under tremendous duress, and we believe the initial shock was more about liquidity than solvency. Extreme volatility in loan portfolio pricing stemming from the COVID-19 pandemic has pressured the sector’s funding model, with no relief from government intervention in sight. Redwood’s management has equal measures of integrity, resolve and experience; if anyone can safely navigate these waters, we like their chances. The team has taken several difficult, decisive steps to shore up liquidity, and we think they have invested (and marked) with appropriate conservatism. The potential upside case is clear, yet we cannot be sure that this unprecedented disruption will not further impair their business. More to follow next quarter.
Other top detractors include several companies that participate in elements of the auto industry (CarMax, Axalta and Liberty SiriusXM) as investors first feared supply chain shocks for auto manufacturers and then demand shocks from fewer vehicle sales and miles driven. There is no doubt that business (and earnings) will be challenged for these (and nearly all) companies in the coming quarters, but we remain confident that their long-term prospects are sound. Colfax’s (CFX, Financial) recent purchase of medical devices and services company DJO (and sale of its Air & Gas Handling business) improved its business mix, but its overall cyclicality and balance sheet leverage had investors heading to the exits. We believe management’s strategy is sound, but we ultimately sold our shares to pursue potentially more attractive opportunities.
On balance, the Fund was a seller of equities in the quarter, including actions that we took towards portfolio reshaping. In addition to Colfax, we closed our positions in Perspecta (PRSP, Financial) and Fortune Brands (FBHS, Financial) to take advantage of the new opportunity set. We also trimmed relative outperformers LICT Corp. (LICT, Financial) and Black Knight (BKI, Financial) to manage their weights as their position sizes rose relative to the rest of our portfolio holdings. In addition, we reduced our position in Expedia Group (EXPE, Financial) by nearly two-thirds in late February and early March as the potential travel slowdown started coming into focus. On the buy side, we continue to build up newer positions at lower price points (e.g. First Hawaiian, Markel and Vulcan Materials), as well as older holdings where investors’ fear appeared overdone (e.g. Liberty Global and Liberty Latin America). We initiated three new positions in the portfolio, including IDEX Corp. (mentioned above), CoStar Group and HEICO Corporation (detailed below). These three companies are characterized by the highest Weitz Quality Scores (Q1’s or Q2’s on a Q1-Q7 ranking) and strong balance sheets with low-to-no net debt.
CoStar Group (CSGP) is the leading provider of data, analytics and marketing services to commercial real estate brokers and tenants as well as the operator of the rental marketplace, Apartments.com. Research Analyst Jon Baker, CFA, details the business and our investment thesis in this quarter’s Analyst Corner feature. HEICO Corporation’s (HEI.A) largest segment designs, manufactures and sells FAA-approved jet engine and other aircraft replacement parts, typically at price points below those offered by original equipment manufacturers (OEMs). With airlines all but grounded, aftermarket demand for HEICO parts and overhaul services has surely suffered. However, we think it is unlikely that air travel is permanently impaired. As planes return to service, HEICO’s value proposition will help them gain market share. HEICO’s conservative balance should allow them to not only survive this temporary halt but to continue their strategy of bolt-on acquisitions at attractive prices to accelerate business value growth.
As we move into the second quarter, much is still uncertain. Although there are some encouraging headlines and governments around the globe are acting aggressively to head off the worst, we are proceeding with caution. Using our quality-at-a-discount or “QuaD investing” framework, we continue to seek (and act upon) investment opportunities which we believe can deliver superior returns over a multi-year time horizon, even while the near-term outlook remains clouded. We appreciate our shareholders’ trust and the opportunity to invest alongside you.
The views and opinions expressed here are those of the portfolio managers as of 04/20/2020, are subject to change with market conditions, and are not meant as investment advice.
